FedEx Pensions Reveal Strange, Murky Rules

Wednesday, June 25, 2003

By TIFFANY KARY

DOW JONES NEWSWIRES

NEW YORK -- Michael Markowski said he noticed something strange about FedEx Corp.'s pension accounting and cash flow in its third quarter that led him to predict the company would lower earnings estimates -- two weeks before it did so. A small, red line showed up on the charts he pores over as head of research at independent research firm StockDiagnostics.com. The line indicated that for the first time in 20 quarters, the delivery company had turned negative in its operating cash flow per share, a measure StockDiagnostics tabulates with its patented algorithms. That led Mr. Markowski to FedEx's balance sheets, where he discovered a pension expense of $907 million that was booked as a prepaid asset for the company's first three quarters of 2003. "Imagine: You can write a check now and take an earnings hit, or simply write it and put it in a drawer and pretend it's an asset," Mr. Markowski said.

Mr. Markowski may be oversimplifying pension accounting, which involves a complicated mix of assumptions, write-downs and estimates about "actuarials" such as mortality rates. But he has stumbled upon the crux of a huge problem -- the opaque nature of pension accounting, something the Financial Accounting Standards Board is attempting to fix. FedEx Plans Severance Deals to Cut More Costs 06/03/03

Accounting experts say there is nothing wrong with the way FedEx booked the $907 million, but they also say it is impossible to project how much of it actually will come as an expense. Analysts also point out that the company has some aggressive assumptions about certain rates uses in its pension accounting, and a business that is fundamentally weakening. Mr. Markowski, like many Wall Street analysts, can't figure out exactly what is going on with FedEx's pension accounting, but he may be on to something. He assumed the company would have to expense the asset at some point and predicted a blow to earnings. Two weeks later, on June 2, FedEx said earnings per share would miss Wall Street's estimates for the first quarter of the 2004 fiscal year and for the full fiscal year. FedEx said at the time that the lower earnings were related in part to significant increases in pension and health-care costs for the year.

Lower Forecast Is Predicted

Mr. Markowski predicts the company will have to lower earnings again and said he can't find consistent statements about pension accounting in FedEx's recent quarterly filings. But Wall Street analysts see little reason for concern. Of the 23 analysts that follow the company, only one rates it at sell. The disconnect between Mr. Markowski's concerns and Wall Street's views arises from the complexity of pension accounting and not from anything illegal on the company's part, accounting experts say. "It is an accounting illusion, but it's one that SFAS 87 creates, not one that FedEx creates," said Neri Bukspan, chief accountant for Standard & Poor's, referring to the Financial Accounting Standards Board rule that defines pension accounting. "We play by the rules of the game," said Eric Jackson, FedEx vice president of communications. FedEx said its chief financial officer and other executives familiar with the company's finances weren't available for comment.

Accounting experts warned, though, that the company's high rate of expected return on its pension assets could make it vulnerable when FASB changes pension accounting rules. A draft of FASB's proposed changes is expected in the third quarter of this year, though specifics haven't yet been announced.

Part of the reason FedEx's earnings, which were 49 cents a share for the third quarter, looked so much better than operating cash flow, which Mr. Markowski calculated to be a loss of 78 cents a share, is because the company doesn't factor items such as pension contributions and costs into earnings. The "smoothing mechanism," designed in part by FASB, allows companies to take excess returns from pension assets and add them to their bottom lines, or, when times are bad, spread out losses. "It's an interesting issue, but you would need to look at several years' worth of balance sheets to figure out exactly what a company is doing," Federal Reserve Board senior economist Steven Sharpe said. Mr. Sharpe estimates that about half of public companies use the smoothing technique, but that it is impossible to tell how aggressively any one company is using it.

Subjective Assumptions

Among all of the subjective assumptions used to calculate pension costs -- such as employee turnover, mortality rates and compensation levels -- analysts have criticized two rates FedEx uses: the rate of return and the discount rate. Several analysts say FedEx's return assumption is too aggressive, and the company will take a hit from earnings if it lowers the rate. The company's rate is 10.1%, down from its previous rate of 10.9%, but above the average rate for S&P 500 companies of 9%. Many consider the average rate high considering market losses have turned many pension funds negative lately.

FedEx's Mr. Jackson defended the company's returns assumptions, saying they are reasonable, considering actual returns have ranged from 10.56% to 13.26% since 1999 and have always come in above assumptions. Mr. Jackson added, though, that the company plans to revisit its current 10.1% assumption sometime in July. He declined comment on how that would affect earnings, citing FedEx's current quiet period. Fulcrum analyst Jeffrey Kaufman, the one Wall Street analyst who holds a sell rating on shares, said he thinks FedEx will be forced to re-evaluate its return assumption "in light of new ideas being considered by the accounting bodies and the SEC." FedEx's discount rate is also high, at 7.1% for fiscal 2002. The average for S&P 500 companies is 6.7%.

Write to Tiffany Kary at tiffany.kary@dowjones.com